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Where China's Domestic Companies Stand to Benefit

Investor concern spans China's economy, but these industries still have plenty of room to grow, especially for local firms.

Morningstar Analysts, 11/30/2011

To get an inside view of the investing landscape in China, we asked Morningstar's Shenzhenbased team of equity and credit research analysts, led by Iris Tan, to give their perspective on the sectors in China’s economy where the best opportunities lie for local, Chinese companies.

Locals Emerge in Construction Machinery
Driven by urbanization and the mass building of infrastructure, the Chinese constructionmachinery sector grew at a compound annual rate of 22.9% over the past 10 years. Sales of Chinese construction machinery are on pace to reach $78.4 billion in 2011, making it the world’s largest market. However, these one-time darlings of China-focused funds have seen their earnings quality deteriorate and orders slow in 2011.

Investors are fleeing the sector over fears of a hard landing by the economy and drastic cuts in fixed-asset investments. Domestic players are trading at 10 times their P/E ratios and three times price/book ratios, close to their historical lows. In the short term, we expect a continuing decline in orders. But over the longer term, investment in infrastructure projects—particularly in transportation and nuclear—should resume once a corruption investigation of the railway ministry is completed and concerns over nuclear safety are addressed.

Foreign companies compete on a fairly level playing field in the sector; market share is split roughly 60%/40% between multinational behemoths (such as Komastu, Hunyadi, and Caterpillar CAT) and their domestic rivals, respectively. The landscape, however, is changing. SANY, Zoomlion, and XCMG Construction Machinery are emerging local players. With ample cash from equity and debt offerings, they have quickly expanded their operations and are taking market share away from foreign competitors. We project that they will see 15% annualized growth for the next five years.

Of these emerging domestic companies, we especially like XCMG. The manufacturer specializes in cranes, compactors, and paver products. Its parent company, Xugong Group, is China’s largest construction-machinery manufacturer. Short-term capital raising and a sharp decline of investment in rail and road construction drove XCMG’s valuation down to near-historic lows. We believe that at its current valuation the stock offers mediumand long-term investors an attractive entry point to a leading player in an industry with double-digit annual growth rates.

There is no denying that XCMG cannot compete with Caterpillar and Komastu on quality, but lower prices, along with a comprehensive service network and sales channels, have won over the majority of domestic customers. In 2010, according to the company, its crane products owned a 53% market share in China. As a government-backed company, XCMG should be able to secure the funds it needs through issuing notes and bonds to finance capital expenditures and acquisitions. Additionally, revenue from its concrete truck and pump business jumped 112.2% in the first half of the year, while gross margins improved 31.22%, a 5-basis-point increase year over year. With a dedicated service and dealer network and a reputable brand, the firm’s crane truck and road-roller products remain the market’s top choices in 2011.

Insurance Business Comes to Life
A young industry in an environment with fast-growing household income, China’s insurance sector increased at a compounded annual rate of 30% from 2000 to 2005 and 24% from 2005 to 2010. By the end of 2010, China’s $214.6 billion in premium income made it the world’s sixth-largest insurance market. It’s a market in which domestic insurers have near total control. (Foreign insurers represent merely 5% of the market.) Although the market in terms of total premium income is huge, per capita it only ranks 61st in the world. Premiums as a percentage of GDP rank 39th.

China’s A-share insurance index is down 27% so far this year after an 18% drop in 2010.

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